Understanding ESG disclosures and why they matter to your organization
With the growing concerns surrounding ESG increasing, investors, advisers and regulators are forced to turn to ESG disclosures. ESG reporting is a fast-moving area and promoting internal ESG achievements benefits organizations and their investors.
In this article, we will discover:
- What ESG disclosures are
- Why ESG disclosures are important
- ESG disclosure requirements
- The challenges and risks associated with ESG disclosures
What are ESG disclosures?
The term refers to the disclosure of data relating to an organization’s environmental, social and governance performance. Such disclosures enable investors to make informed decisions by identifying companies that may pose a risk or perform less well due to sustainability or ESG failings.
Why are ESG disclosures important?
Not every jurisdiction has rules on ESG disclosures, and much guidance focuses on best practices or best efforts rather than mandatory disclosures. Irrespective of this, the growing consensus is shifting towards a culture where ESG disclosures are expected and as a result, their importance continues to grow. Some of the key reasons ESG disclosures are important include:
- Attracting investors: A 2019 survey conducted by Harvard Business Review among the investment and asset management community found that ESG issues were 'almost universally top of mind' among the 70 senior executives interviewed. Issues like climate risk, the quality and diversity of the board the quality and diversity of the board sustainable supply chains and cybersecurity are now routinely included within investment advisers' and asset managers' due diligence.
- Regulatory imperatives: In the EU, the Sustainable Finance Disclosure Regulation (SFDR) came into effect in March 2021. While it applies mainly to EU organizations, it also has implications for U.S. companies doing business in the EU. Complying with regulations such as the SFDR ensure that companies mitigate future fines and legal battles.
- Transparency: ESG disclosures give companies an opportunity to be fully transparent with their stakeholders about growing ESG issues. Providing an insight into things such as ESG performance and the positive and negative impacts that a company has on the environment demonstrates clear awareness and a desire to drive positive impact.
Regardless of whether regulations like the SFDR personally impacts you, its existence speaks to a corporate landscape where transparency and proactive disclosure on ESG issues is the expectation rather than the exception. The importance of ESG disclosures is, therefore, likely only to grow.
What are the drivers for ESG disclosures?
In an episode of Diligent's Inside America's Boardrooms, ESG Accountability: Closing the Gap Between Investors & Boards, Cindy Fornelli, Board Member at TPVG, stated her belief that companies today are 'lazer focused' on disclosures. What's driving this level of attention?
Deeper understanding by corporates of the importance of ESG: As Nasdaq state, 'Proactive and integrated ESG policies can widen a company's competitive moat relative to other industry players' — all the more so if this is publicly acknowledged, and this is something companies are increasingly alive to.
Enthusiasm among institutional investors: Until even quite recently, asset managers had to convince investors of ESG investing's benefits. Today, as Eva Halvarsson, CEO of Swedish pension fund AP2, notes, 'We used to have to put a lot of effort into explaining to our colleagues in the broad investment community why ESG is important. [...] Now the focus is on how we can most effectively capture value from ESG integration.'
Asset managers like BlackRock evidence this. For instance, BlackRock added its voice to the ClimateAction100+ movement, an investor-led initiative that encourages the world's largest corporate greenhouse gas emitters to take action on climate change.
Greater accountability, particularly at a personal level for directors: Harvard Business Review's 2019 survey of investment managers and advisers led them to claim that 'corporate leaders will soon be held accountable by shareholders for ESG performance — if they aren't already.' This accountability provides a powerful incentive for firms to take the steps and gather the data needed to state their ESG performance proactively.
A broader movement towards diversity and social justice: Fornelli notes that in the wake of the black lives matter movement and resulting wider awareness of social injustice, 'investors are tuning into that [...] and flexing their muscles,' demanding action from corporates that fall short of expectations on diversity, labor relations and other related issues.
Commercial benefits: Not only has ESG investing been shown to deliver results, putting corporates under pressure to up their ESG performance, ESG disclosures, too, can drive business success.
In 2017, Nordea Equity Research reported that companies with the highest ESG ratings between 2012 and 2015 outperformed the lowest-rated firms by as much as 40%. Increasingly activist and socially aware investors are likely to accelerate this trend further.
More recently, between 2015-2020, NYU Stern discovered a favorable correlation relationship between ESG and financial performance for 58% of the examined “corporate” studies.
Increased focus on ESG data: Several years ago, Nordea Equity Research predicted that investor spends on ESG data could top $1bn by the end of 2021. Now we’re seeing spend figures for ESG data and ratings vary from $175,000 to $360,000, according to an ERM's statement. In a world where ESG scores and ratings are increasingly crucial to adviser and investor decisions, it's not surprising that corporates' focus on ratings is growing in tandem with investors' reliance on them.
Legislative and regulatory pressures: In the U.S., the prevailing winds are towards a greater focus on governance; some see President Biden's nomination of Gary Gensler as SEC chairman to sign that ESG disclosures may become more commonplace.
Are ESG disclosures required?
Universally, the direction of travel is toward required disclosures. We’ve seen this with the recent SEC climate disclosure proposals passed in November 2022 and the gradual build-up of numerous frameworks (GRI, SASB, TCFD, etc.).
Many countries and regulatory bodies have been encouraging or mandating ESG disclosures for companies, especially when publicly traded. These requirements vary by jurisdiction and industry. For instance, some stock exchanges and securities regulators have started to mandate specific ESG reporting for listed companies.
For example, in April 2023, a PwC report highlighted that the Qatar Stock Exchange guidelines are currently voluntary for companies listed on the stock exchange but that companies can expect material ESG metrics and sustainability reporting to become mandatory.
The U.K. Department of Work and Pensions introduced the Pension Schemes Act 2021, which requires U.K. pension schemes statutorily to consider, assess and report on the financial risks of climate change within their portfolios. It was only one year on, in March 2022, when the U.S. Securities and Exchange Commission (SEC) announced the new climate disclosure proposal.
In many countries, it’s clear that some element of ESG disclosure is either mandated or heading that way. Regardless of your locality or whether disclosures are legislated, there is a growing expectation by rating agencies, investors and other stakeholders that ESG performance will be reported.
How Many Countries Require Mandatory ESG Disclosures?
There are currently 29 countries that have put regulations in place to make ESG disclosures mandatory. ESG data disclosure requirements vary from country to country, depending on the specific regulations applicable to each company. Some of countries that form the list are:
- United Kingdom: Following the UK’s Net Zero Strategy and their commitment to making the UK financial system the greenest in the world, the UK became the first G20 country to make it mandatory for their largest businesses to disclose their climate-related risks and opportunities.
- United States: The SEC’s proposed climate disclosure contains mandatory requirements for companies to follow. It also contains “comply or explain” requirements, for example, if a company does not have an audit committee financial expert, it can explain why.
- EU Members: In November 2022, the European parliament passed the Corporate Sustainability Reporting Directive (CSRD) which covers approximately 11 700 large companies and groups across the EU. Prior to the CSRD taking effect, companies must comply with similar rules outlined in the Non-Financial Reporting Directive (NFRD).
Identifying the challenges and risks associated with ESG disclosures
ESG disclosures may be the way forward, but there are some challenges — and even some risks — associated with delivering them.
Challenges associated with ESG disclosure
A lack of understanding and historical focus
Above, we referred to findings of an HBR survey showing that investment managers and advisers are routinely prioritizing ESG issues within investment decisions. Corporates may historically have lagged on this focus; a 2019 HBR article noted that U.S. executives routinely under-estimate the amount of their shares owned by firms employing sustainable investing strategies. They estimate that such companies own 5% of their stocks, when in fact, around 25% are owned by companies focused on sustainable investing.
ESG moves fast, and this may have progressed in the past two years. But our own research supports the view that while ESG may be a conceptual focus for many organizations, plenty have not yet operationalized their ESG objectives — and this can feed through into their prioritizing of ESG disclosures.
Difficulty obtaining robust data
This has traditionally been a significant challenge for businesses wanting to measure and report on ESG objectives. In many instances, as flagged by Barbara Berlin, Managing Director of PWC's Governance Insights Center in a recent edition of Diligent's Inside America's Boardrooms, data does not come from areas of the organization with in-built IT or measurement systems. For instance, D&I and workplace safety plays out on factory floors where there may be no automatic way to capture the metrics needed. Information can therefore be more anecdotal than data-led.
A good governance model around data collection is essential here. Organizations need to ask who is reviewing the data received and who is accountable for it at a management level. In Berlin's words, data needs to be 'investment grade'; businesses need to implement rigorous controls and policies around data gathering and capture.
Understanding what's required
What are investors looking for in ESG reporting? Again, a lack of clear and consistent frameworks can muddy the waters here. You need to understand what investors want from your ESG disclosures and ensure your data can deliver it to them.
Risks Associated with ESG Disclosure
Are there risks associated with ESG disclosures? You may think that sharing your ESG successes can only be a positive. But of course, opening your organization to public scrutiny always comes with a risk that your progress will be scrutinized and your achievements questioned.
As we noted above, obtaining robust ESG data is a challenge for many organizations. Barbara Berlin points out that boards — who might be the public face of this data — need to be comfortable that good high-quality data is coming through the pipeline to inform the organizational ESG story.
To address this, many boards seek independent assurance that the data they are using is sufficiently accurate, whether via their internal audit team, external auditors or third-party advisers. Interrogating the data before it's shared gives board members the confidence they need in their metrics.
Absence of standardized frameworks
ESG disclosures should help an organization to 'tell their story' about their approach to environmental, social and governance issues. A lack of clear guidance and consistent frameworks to define the shape of these disclosures means that businesses need to be 'somewhat creative' in structuring these stories.
Whether organizations report via proxy statements, their website, their filings, or their sustainability report, telling a cohesive story is essential. Non-financial metrics can be as important as the financials here. Investors and other stakeholders are increasingly using these to inform their decision-making, but often this is where the data can be haziest. As Berlin notes, 'Board members will want to be making certain that those non-financial metrics have the same type of rigor as financial metrics.'
Data needs to be consistent, reliable and high-quality. Companies need to identify what aspects of ESG are most important to them and then leverage the external frameworks and standards that do exist to build their metrics into a coherent story that stands up to scrutiny.
Lack of accountability and involvement
In its article The Investor Revolution, Harvard Business Review claims that 'companies need to increase middle managers' involvement in material ESG issues. If ESG is a top-of-mind issue for the board, it's certainly something that middle management should be prioritizing and making themselves accountable for. Not doing so risks a lack of focus on an area that is increasingly on activists' radar.
Build ESG disclosures on solid foundations
Hopefully, you now have a clearer idea of the current state of play on ESG disclosures, why they are essential, and some of the challenges you may face in implementing them — along with strategies for overcoming those obstacles. Robust data is a core foundation of reliable ESG disclosures and one of the most significant barriers for companies to operationalize their ESG principles. If you would like greater confidence in your ESG metrics, Diligent's ESG Solutions can help you to take a more structured approach to ESG measurement and reporting.
ESG Solutions can propel your ESG disclosures to the next level. It is underpinned by market-leading solutions that enable you to build robust ESG metrics and benchmark and is supported by our Operationalizing ESG Roadmap — an invaluable resource for all organizations. Visit our website to find out more.